Note to Directors: It’s Who You Know that Counts

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In the wake of corporate financial scandals like those that transpired at Enron and WorldCom at the start of this century, companies began to boost the pay of directors in the hopes of finding sharp-eyed boards that could catch management criminals red-handed. In fact, research cited in a recent research paper found that median director total compensation almost tripled from 1997 to 2010.

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Even so, while a great deal of research has been done on executive compensation, relatively little has been done on what factors determine board pay. More recently, researchers have found that director compensation can explained by factors like director qualifications experience. Now, however, comes evidence of another reason that determines what a corporation pays its directors: how impressive the directors’ list of contacts is.

Indeed, in a paper produced by a trio of academic researchers, the authors report that they find “strong evidence” that corporations place a high monetary value on how well-connected their directors are. On average, they claim, “one standard deviation increase in boardroom connectedness increases overall board pay by about 57%.”

Further, in dollar terms, “one standard deviation increase in boardroom social capital is associated with a more than $380,000 increase in total compensation,” say the authors: Stephen Ferris, University of Missouri; David Javakhadze, Florida Atlantic University; and Yun Liu of theKeck Graduate Institute.

The authors also contend that boards with great contacts tend to be better watchdogs and thus can better curb corporate conflicts of interest “to protect the interest of shareholders.”

Companies most likely to benefit from well-connected boards might also pay more for them. Such companies can be ones with strong growth potential, a need for financing, big conflict-of-interest agency costs, or the need to recover from adverse events, according to the paper.

“In addition, firms might value specific board connectedness (such as connections with large firms or within industry) more,” write the authors of the paper, “The Price of Boardroom Social Capital: The Effects of Corporate Demand for External Connectivity.”

The researchers’ metric of the monetary value of board connectedness is “social capital,” which they define as “network benefits derived from Directors’ personal associations with corporate executives or Directors of other firms, on board total compensation.”

While all directors at a given company tend to get the same basic pay, “those with more networks enjoy more leadership positions and sit on more committees, and are therefore paid more,” according to the paper.